Corporate Communicator - Fall 2015: SEC Proposes Rules for the Clawback of Executive Compensation

by Snell & Wilmer
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Dear clients and friends,

In this issue of the Corporate Communicator, we bring you an article about the SEC’s recently released proposal to adopt rules for the clawback of executive compensation. The proposal is already controversial and it may prove to have far-reaching consequences on how executive compensation arrangements are structured.

Very truly yours,

Snell & Wilmer L.L.P.
Corporate & Securities Group

SEC Proposes Rules for the Clawback of Executive Compensation

by Cheryl Ikegami, Tom Hoecker and Greg Gautam

On July 1, 2015, the Securities and Exchange Commission (“SEC”) proposed rules to implement Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which requires the SEC to adopt rules directing the national securities exchanges to prohibit the listing of any security of an issuer that is not in compliance with certain requirements relating to the “clawback” of executive compensation. The proposed rules raise a number of questions and uncertainties, some of which we discuss below. Such uncertainty could beget litigation, either by an officer against whom a clawback is being asserted or by the shareholders (assuming that the courts infer a private right of action in this context), or by both. In addition, if the SEC or the relevant exchange disagrees with an issuer’s application of its clawback policy, it is unclear how or if the resulting failure can be cured. These types of grey areas are particularly unwelcome when the consequence of second guessing is a potential delisting. Comments on the proposed rules are due by September 14, 2015.

Application to Listed Issuers

The new rules would apply to all issuers of listed securities, whether debt or equity, with limited exceptions. There is no exception for smaller reporting companies, emerging growth companies or controlled companies.

Restatements That Would Trigger Recovery

The proposed rules would require a clawback in the event the issuer is required to prepare an accounting restatement due to the “material noncompliance” of the issuer with any financial reporting requirement under the securities laws. The proposed rules define an accounting restatement as the result of the process of revising previously issued financial statements to reflect the correction of one or more errors that are material to those financial statements.

While the determination of what is an accounting restatement is based on materiality, the rules do not further describe or elucidate materiality in this context. The SEC does note, however, that issuers should consider whether a series of immaterial error corrections, whether or not they resulted in amendments to previously filed financial statements, could be considered a material error when viewed in the aggregate. It is not clear what factors would weigh in favor of or against this result. Based on this, however, it is unclear whether and/or when a financial statement revision or “little r” restatement could trigger the clawback rules.

Determining the Accounting Restatement Date

Under the proposed rules, issuers would be required to recover excess incentive-based compensation received during the three completed fiscal year period preceding the date on which the issuer is required to prepare an accounting restatement (the “three-year look-back period”). The date on which an issuer is required to prepare an accounting restatement is the first to occur of:

  • the date the issuer’s board of directors, a committee of the board of directors, or the officer or officers of the issuer authorized to take such action if board action is not required, concludes, or reasonably should have concluded, that the issuer’s previously issued financial statements contain a material error; or
  • the date a court, regulator or other legally authorized body directs the issuer to restate its previously issued financial statements to correct a material error.

The determination is to be applied on an objective basis -- the question being when a reasonable issuer, based on the facts available, would have concluded that the previously issued financial statements contain a material error. There is little guidance on what factors might inform this “objective” determination. The SEC refused to use the date of the original financial statement error as the starting point for the three-year look-back period because they felt that such a test would not fully effectuate the purposes of the rule. Similarly, they declined to use the actual date the restatement is filed as the test, because such a date could be manipulated.

Executive Officers Subject to Recovery Policy

The definition of executive officer in the proposed rules is modeled on the definition of “officer” in Rule 16a-1(f) of the Securities Exchange Act of 1934, as amended, and therefore, generally would mean the issuer’s Section 16 officers. The rules would apply without regard to an officer’s fault or responsibility for preparing the problematic financial statements.

The recovery policy would require recovery of excess incentive-based compensation received during the three-year look-back period by any executive officer or former executive officer who served as such during the performance period for that incentive-based compensation. This would include compensation derived from an award made before the individual becomes an executive officer, as well as inducement awards in new hire situations, as long as the person served as an executive officer at any time during the performance period for the award. The person need not be an executive officer when the compensation is “received.”

Applying these rules to an issuer’s Section 16 officers could be problematic because the determination of an issuer's Section 16 officers is subject to a considerable degree of judgment and variation among issuers. In addition, while, as proposed, all incentive-based compensation received during the look-back period is subject to clawback, the SEC requests comment on whether the required clawback should be subject to proration when the officer is an executive officer only during a portion of the look-back period. Also, what constitutes the “performance period” may not always be clear. For example, the SEC should clarify whether a clawback would be required for an award as to which there is a one-year performance period based upon financial metrics that are restated, followed by a two-year time-based requirement of employment, and the person serves as an executive officer only during a portion of the two-year time-based period.

Incentive-Based Compensation

Rather than identify each type or form of compensation to which a recovery policy would apply, the proposed rules define “incentive-based compensation” in a principles-based manner as any compensation that is granted, earned or vested based wholly or in part upon the attainment of a financial reporting measure. Financial reporting measures are measures determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements, measures derived wholly or in part from such measures, and stock price and total shareholder return (“TSR”).

In determining to include stock price and TSR as financial reporting measures for purposes of the rule, the SEC acknowledges that it may be difficult to establish the relationship between an accounting error and the stock price and discusses some methodologies for doing so. The rules therefore permit issuers to use reasonable estimates when determining the impact of a restatement on stock price and TSR and require them to disclose the estimates. The SEC seeks comment on whether an independent third party should be required to assess management’s calculations of the recoverable amount in this context. The inclusion of stock price and TSR as financial reporting measures is a controversial aspect of the proposed rules. Because the issuer would be required to disclose and justify the estimates used to determine the impact of a restatement on these measures, third party calculation may be advisable as a practical matter even if not required as part of the rule. From a tax perspective, it is unclear whether the use of estimates would have any adverse tax consequences on the deductibility of compensation intended to comply with Section 162(m) of the Internal Revenue Code.

When Compensation is Received

As proposed, incentive-based compensation would be deemed “received” in the fiscal period during which the financial reporting measure specified in the incentive-based compensation award is attained, even if the payment or grant occurs after the end of that period. An award that is subject to both a financial reporting measure and a time-based vesting schedule is deemed “received” when the financial reporting measure is attained, even though the award is still subject to the time-based vesting condition.

The SEC states that the date of receipt is not affected by ministerial acts or other conditions necessary to effect payment or issuance, such as calculating the amount earned or obtaining the board of directors’ approval. It is not clear whether this should be true even if the award or plan expressly requires board determination of satisfaction of the condition and of the final amount earned or if the board exercises negative discretion to lower the amount actually granted or vested.

Determination of Recoverable Amount

The proposed rules define the recoverable amount as the amount of incentive-based compensation received that exceeds the amount that otherwise would have been received had it been determined based on the accounting restatement. For compensation based on the stock price or TSR, where the amount of erroneously awarded compensation is not subject to direct mathematical recalculation, the recoverable amount should be determined based on a reasonable estimate of the effect of the accounting restatement on the applicable measure.

The recoverable amount would be calculated on a pre-tax basis with no credit for taxes previously paid on the compensation for purposes of the recovery amount to which the company would be entitled. The officer may be entitled to a deduction for any returned amounts for the year in which such amounts are repaid to the issuer. However, because the taxes paid on the original compensation awarded may not be fully recoverable by the officer after a clawback, this could result in the officer having to pay more on an after-tax basis than was originally received.

For nonqualified deferred compensation, the executive’s account balance or distributions must be reduced by the excess incentive-based compensation contributed to the plan and the interest or other earnings accrued thereon. To the extent the excess incentive-based compensation was used to calculate a benefit under a supplemental executive retirement plan or a defined benefit pension plan, the recovery could take the form of an adjustment to the benefit formula (where the excess compensation is deducted from the benefit formula) and a recovery of any related distributions. For account balance plans, the officer’s account balance or distributions could be reduced by the excess incentive-based compensation contributed to the plan and the interest or other earnings accrued thereon. The proposed rules do not address how an issuer should deal with any ERISA exposure that might arise in connection with the reduction of an accrued benefit.

For cash awards made from a bonus pool, the size of the bonus pool would be recalculated and potentially reduced based on the restated financials. If the restated pool is less than the aggregate amount of individual bonuses received from it, the excess amount of the individual bonuses would be determined pro rata.

For equity awards that are still held at the time of restatement, the recoverable amount would be the number received in excess of the number that would have been received applying the restated financial reporting measure. Where options or SARs have been exercised, but the underlying shares have not been sold, the recoverable amount is the number of shares underlying the excess options or SARs. If the shares have been sold, the recoverable amount would be the sales proceeds received by the executive officer with respect to the excess number of shares. Further guidance may be required on how to effect a clawback where some of the shares received have been sold and some are still held.

Exercise of Board Discretion as to Recovery

The proposed rules provide that an issuer must recover erroneously awarded compensation except to the extent that it would be impracticable to do so, and that recovery would be impracticable only if the direct expense paid to a third party to assist in enforcing the policy would exceed the amount to be recovered, or if recovery would violate home country law and a legal opinion to that effect is obtained. Before determining not to pursue recovery on this basis, the issuer would first need to make a reasonable attempt to recover, document its attempts and provide that documentation to the exchange. A decision to settle for less than the full recovery amount would be subject to the same constraints as for a determination to forgo recovery.

The proposed rule appears to mandate recovery, not just the pursuit of recovery. It is unclear what the result would be if litigation to recover/collect is brought, but that litigation is lost. What if, for example, a court determines that recovery cannot be required because there is no specific provision for clawback in the award agreement? What if judgment is achieved, but the officer cannot or does not pay? It is not clear how far an issuer must go to achieve the recovery. It is also not clear how to enforce a recovery against a former officer of a company who received incentive-based compensation under an award agreement that did not contemplate the necessity for such a clawback. Keep in mind that because failure to recover erroneously awarded compensation or otherwise comply with the clawback policy would involve a listing violation and not a violation of law, courts may be less likely to rule in favor of a company in such a contract dispute.

The proposed rules allow the issuer to exercise discretion in how to accomplish recovery, but the recovery must be “reasonably prompt.” Note that any recovery attempt that involves offsetting future payments of deferred compensation could implicate Section 409A of the Internal Revenue Code. The SEC seeks comment on whether the issuer should be allowed to recover excess compensation by netting overpayments with underpayments that result from restating financial statements for multiple periods during the three-year recovery period, implying that such netting may not otherwise be permitted.

Indemnification and Insurance

The issuer may not indemnify an officer for recovery amounts and may not pay or reimburse the executive for premiums for insurance to fund potential recovery amounts.

Disclosure Requirements

The proposed rules include disclosure requirements intended to cover both the substance of the recovery policy and how the issuer implements the policy in practice, including disclosure of clawback amounts that are not being pursued or that remain outstanding after a specified period of time. There would also be a requirement for XBRL disclosure of certain of such information.

Transition and Timing

The SEC proposes that each exchange file its proposed listing rules not later than 90 days after publication of final SEC rules, that such listing rules be approved by the SEC and be effective not later than one year after such publication and that each listed issuer adopt its recovery policy not later than 60 days following the effective date of the exchange rules. Each listed issuer would then be required to recover all erroneously awarded incentive-based compensation received by executive officers on or after the effective date of the final SEC rules as a result of attainment of a financial reporting measure based on or derived from financial information for any fiscal period ending on or after the effective date of the final SEC rules. It is not clear how restatements that occur between the effective date of the final SEC rules and the date that exchange rules become effective and issuers are required to adopt their policies are to be treated.

Some General Thoughts

The rules ultimately adopted and even the proposed rules are likely to have a weighty impact on the structure and measures used for ongoing incentive-based compensation awards for senior level officers at listed issuers. Officers may seek a greater percentage of their compensation in a form that would not be subject to a no-fault clawback, and compensation committees may be inclined to structure future compensation packages to mitigate the potential impact that these rules may have, especially for officers who have no responsibility for the financial statements of the company. This could result in a break on recent trends to link compensation and performance or at least to tie any performance metrics to financial reporting measures. It also may reduce reliance on stock price and/or TSR as performance metrics.

While final clawback rules may not be adopted in the near future, issuers should consider the potential impact of these rules now and should ensure at a minimum that awards and contracts with executive officers or persons who could become executive offers contain provisions that allow recovery as required under SEC and stock exchange rules and that compensation committee charters give the Committee the authority to enforce any excess compensation recovery that might be required to comply with SEC and stock exchange rules.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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